Harnessing the benefits of Financial Innovation – Part 3

March 22, 2016

Harnessing the benefits of Financial Innovation rather than falling prey to its demons

by Rajat Bhatia

LESSONS FROM THE WAVE OF FINANCIAL INNOVATION

Perhaps the most important lesson from the wave of Financial Innovation is that Derivatives, Structured Products and Financial Engineering are now an intrinsic part of our global financial landscape just as modern information technology has moved banking from handwritten ledgers to computers to laptops and now to smart phones. However, as this technology driven financial innovation, where people with PhDs in Physics and Mathematics transform the financial products we trade and use, becomes ubiquitous, we have no choice but to learn lessons from the financial disasters and harness the benefits of financial innovation rather than fall prey to its demons. So what are these lessons:

1. USE LEVERAGE JUDICIOUSLY: Leverage is a double edged sword. Yes it makes for spectacular returns when the markets are in sync with the positions you have on your books but as the London Whale disaster at JP Moran in London have shown us, leverage can cause a financial meltdown faster than we can think.

2. UNDERSTAND WHAT RISKS YOU HAVE: Every business has Risks embedded I its natural operations. Every international airline is exposed to a triumvirate of financial risks – Currency, Interest Rates and Commodity Price Risk in addition to various Operating Risks such as safety, delays and engineering breakdowns. Every oil producer is exposed to both interest rate risks on its borrowings and commodity price risk on the crude oil that it produces. Petroleum Refining companies, similarly are exposed to Refinery Spread risk and electricity producers in deregulated energy markets have to deal with risks emanating from the price of electricity they sell and from the price risk of the feedstock they have to buy.

3. THOROUGHLY ANALYZE HOW TO MODIFY THOSE RISKS USING DERIVATIVES: The biggest advantage of a robust and liquid market for derivatives is that they enable the modification of risks present in a firm’s normal operating business to risks on which the firm has a clear view. Currency swaps have enabled those firms borrowing in low interest rate but strengthening Yen to convert their liabilities into a falling US Dollar in the 1980s and 1990s.

4. DELVE INTO THE NITTY GRITTY OF THE STRUCTURED PRODUCTS THAT YOU BUY: One of the often heard complaints in the derivatives industry in response to financial disasters is “Oh, we did not understand the products that were sold to us”. Well, while it is true, that many banks have been guilty of camouflaging the true risks in the structured products that they sell to both investors and liability managers, the million dollar question that Corporate Treasurers, CFOs and Fund Managers who use derivatives fail to answer is “What about you, what did you do to analyze the financial products that you were buying”. Is it not the duty of those entering into innovative structured finance transactions to thoroughly analyze what they are buying rather than rely merely on what the banks are selling? Some well know banks had formed groups with euphemistically sounding names like “Financial Risk Management or FRM group” whose goal was to generate business by getting unsuspecting clients to write naked options, often leveraged 10 times. As an banker responsible for structuring and marketing derivative and structured products to clients in Asia Pacific, I was amazed by the kind of deals that clients had already entered into. By reverse engineering these heavily camouflaged structured products, two things became evident – (1). the clients had no clue about the risks in the financial products they had purchased and (2). The banks had leveraged up naked options to unbelievable levels. Needless to say, the end result was disastrous for the clients with losses as high as a hundred million dollars for some manufacturing companies where the operating margins are often thin. 5. TREAT RISK MANAGEMENT AS AN ESSENTIAL RATHER THAN AS A COST CENTER: In many organizations, Risk Management is not seen as a profit center but as a cost. However, what these organizations do not realize that avoidance of a huge loss is essentially equivalent to making the same amount of money. Even in major banks, the Risk function was relegated to the mid-office and not considered to be front office. But in reality, managing risk is the flip side of taking risk. So risk management and trading are essentially the two sides of the same coin. Risk Management is a function which instead of being seen as a cost center should be seen as a “loss reduction center”, which in my view is the same thing as a “profit center”, because a trading profit and a reduced loss tantamount to the same thing.

6. INVEST IN ONGOING EDUCATION IN RISK AND DERIVATIVES: In many organizations including major banks, financial education is seen as a cost which should be minimized rather than as an essential investment in human capital. This myopic approach has had and can have devastating consequences, because errors resulting from work done by human capital that is not adequately trained can lead to disastrous consequences. Even at bulge bracket investment banks, there have been instances of rookies or untrained derivatives sales people selling dangerous structured products to investors who are equally untrained and unaware of the risks they are taking on. One investment bank that was an exception to this was Bankers Trust Company, who made their new hires in the derivatives group spend two years learning about financial engineering including writing code in C++.

This, of course, is just a teaser to what you can expect at our 2-day Management Development Program on Structured Products and Financial Engineering by Rajat Bhatia on 28th and 29th March, 2016. Enrol Now! Seats are limited!